Sunday, June 20, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 7

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman takes the reader through a multitude of studies conducted by different groups of researchers, spanning different decades, and across both bull and bear markets. The studies conclude that stocks with low Price to Book ratios, low Price to Earnings ratios, low Price to Cash Flow ratios, and high dividend yields outperform the market. Conversely, stocks with low yields and high P/B, P/E and P/CF ratios severely underperform the market. Many of these studies even accounted for the levels of systematic risk of the stocks under study, and came to the same conclusions.

In an all-encompassing study, Dreman studied the returns of a 25-year strategy (ending just before the book’s publication) involving annual switching into the quintile of the market’s lowest priced stocks. The study found that low P/E stocks returned an astonishing 19% per year (low P/B: 18.8%, low P/CF: 18%, high-yield: 16.1%) compared to the market’s return of 14.9%.

Seeing as how 1970 to 1996 was a fairly bullish period for the market, Dreman also studied price performance during bear markets, and once again cheap stocks outperformed. This time, the high-yield dividend stocks took the top honours (negative returns of 3.8% per year, versus the market’s return of negative 7.5%), but stocks with low P/E, low P/B and low P/CF ratios also outperformed the general market.

Despite all the evidence, why are contrarians and value investors a small minority of market participants? Dreman argues the problem is psychological. Investors get caught up in new ideas, and despite their better judgement (including all the evidence cited above), they can’t bring themselves to invest in companies that the market has beaten down. This makes them go for IPOs of glitzy companies like Planet Hollywood and SpyGlass at P/E ratios of 100+ times earnings instead of boring companies that have been around a while that trade with small P/E or P/B ratios.